Economics Letters

North-Holland

247

17 (1985) 247-252

A LINEAR ALGEBRAIC PROCEDURE FOR SOLVING

LINEAR PERFECT FORESIGHT MODELS
Gary ANDERSON
Federul

and George MOORE

Reserve System,

Received

Washington,

DC 20551,

USA.

6 July 1984

This paper presents a failsafe method for analyzing any linear perfect foresight
computes the reduced-form
solution or indicates why the model has no reduced

model. It describes
form.

a procedure

which either

1. Introduction and summary

Using currently
available methods, it is a laborious
and error-prone
task to solve dynamic
economic models in which expectations
of the future affect the present equilibrium.
The undetermined coefficients
methods developed by Muth (1961), Sargent (1979), Whiteman
(1983) and
others are quite difficult to apply in models sufficiently rich in detail for plausible policy analysis.
Our goal here is to present a method for analyzing dynamic models that is easy to apply in practice.
This paper presents a failsafe method for computing the reduced form of a general linear perfect
foresight model. It describes a simple computational
procedure which either computes the reducedform coefficients of a model or indicates why the model has no reduced form.

2. The structural model

The structural model we analyze includes a linear homogeneous difference
for period t depends on the solution for periods both prior and subsequent

equation
to t,

whose solution

t > 0.

i
HiX,+, =O,
;= __7

Both T and 0 are positive,

x, = x;,

t=

0)
and X, is an L dimensional

-7,

..)

real vector. The initial

conditions

(2)

-1

are given by history.

* The views expressed here are those of the authors and do not necessarily represent
We would like to thank Richard Porter for his helpful comments and Anil Kashyap
0165.1765/85/$3.30

0 1985. Elsevier Science Publishers

B.V. (North-Holland)

the views of the Federal Reserve System.

for his valuable programming
assistance,

Now, suppose
two restrictions:

that the L

(a) The origin is the unique

A* = 0

then

L real coefficient

{ H,:i = -7,

matrices

. . . , 0) satisfy

the following

steady state of eq. (1). That is, if

X* =O.

(b) For any set of initial conditions

{ X,: t > 0) such that lim,_,X,

{ X,: i = - 7,
= 0.

. , -1).

eq. (1) has a unique

solution

sequence

Eqs. (1) and (2) together with assumptions

(a) and (b) will be called model H.
We can show that model H has a reduced form representation
relating the solution sequence
entirely to its history: there is a set of L X L real matrices ( B,: i = -7, . , - 1) such that the unique
stable solution to eq. (1) can be written as

X,=

2 B,X,+,,

t > 0.

(3)

,= -7

Section 3 presents a simple procedure

(b). Given the coefficient matrix
H=

[H_,...

the procedure
B=

[B_,...

for determining

whether

He],
computes

a model satisfies conditions

(a) and

(4)
the reduced-form

B_,]

coefficient

matrix
(5)

for any model satisfying assumptions

(a) and (b).
We emphasize
that the specification
of model H places no restriction
on the rank of H,.
Assumption
(a) is the only rank assumption
included in the model. In the natural specification
of
many structural models, H, is singular.
The non-singularity
condition of assumption
(a) is a weak restriction on the coefficient matrices
H,. The sum of the coefficient matrices must be full rank if the model is to have a unique steady state.
Assumption
(b) is a stronger restriction on the structural coefficient distribution.
Our procedure is
a generalization
of the familiar saddlepoint
analysis for perfect foresight models, and assumption
(b)
requires that the model have the same saddlepoint
property.

3. Summary

of the procedure

By requiring that model solutions ultimately converge to the steady-state equilibrium,

saddlepoint
analysis constrains
the initial state of the economic system. The assumption
of the economic model
specify which components
of the state vector are fixed by history and which components
are free to
adjust to ensure that the model solution converges to the steady state. After transforming
the original
structural equations of the model into an associated state-space representation,
our procedure applies
the stability criterion to exclude potential solutions which never converge to the steady state.

The process of casting the original model into the state-space representation
generates a set of
auxiliary initial conditions
that must be satisfied by the state vector in addition
to the stability
conditions and the historical initial conditions. These auxiliary initial conditions in conjunction
with
the stability conditions
determine the models reduced form expressing current values of the model
solution entirely in terms of lagged values. The reduced form together with the historical initial
conditions determine a unique solution to the structural equations converging to the steady state.
We summarize the procedure as a fourteen-step
algorithm. Anderson and Moore (1983) contains
our proof that the procedure verifies assumptions (a) and (b) and computes B after a finite number of
iterations.
Initiulization
(i) Verify that Cf_ _,H,
(2) CH, is non-singular.
Hz= [H_,...
Auxiliary

HO],

is full rank. If CH, is singular,

Initialize H and Q,

the steady state is not unique.

Q := null matrix.

initial conditions

(3) Compute the singular values, {p,: i = 1, . . . , L}, and left singular vectors, V, of H,. Sort the
p, small-to-large
and order the columns of V conformably.
If I*, f 0, i = 1, . . . , L, then H, is
non-singular;
go to step (9).
(4) H, is singular. Premultiply the coefficient matrix by VT to annihilate I-rank (H,) rows of HO,
Hz= V*H.
(5)

Partition

q:o
.

[ r

the resulting

coefficient

matrix

as

:= H,

The matrix q has L-rank (HO) rows and L( T + 0) columns:

columns.
(6) Include q among the auxiliary initial conditions,
Q :=

Stability
(9)

rows and L( T + 1 + 0)

.!. .
4 1

(7) Now, shift the matrix

(8)

r has rank (H,)

q to the right in H by L columns,

Go to step (3).
conditions
H, is non-singular.

P=H,-[H_I...

HO_,].

Solve for coefficients

expressing

X,+@ in terms of X 1-7 .f.,

X Ii&13

G. Anderson,

250

(IO)
4

Construct

:=

p:* .

G. Moore

Solwng

linecrr perfect

foresrght

models

the matrix

where Z is an L(T + 8 - 1) dimensional

identity matrix.
(II) Compute W, a matrix of row vectors spanning the left invariant
subspace of A associated
with roots outside the open unit desk [e.g., Stewart (1976)]. The matrix W contains
the stability
conditions we use to verify the saddlepoint
property [Anderson and Moore (1983)].
Reduced form
(12)

Concatenate

Q:=

.;.
[

(13)

initial

conditions

and the stability

conditions,

I
.

Partition

[Q&Al

the auxiliary

Q,

:= Qv

where QL has Lr columns and QR has LB columns.

(14) Let n be the number of rows in Q.
(4 If n < LB, then assumption (b) is violated; there are many solutions converging to the origin
from any initial condition.
(b) If n > LB or n = LB and QR is singular, then assumption (b) is violated; there exist initial
conditions for which there are no solutions converging to the steady state.
If n = L8 and QR is non-singular,
then set (B_, . . . BP,) to the first L rows of -Q, QL.

cc>

X,:X,=

B,X,+;,t>,O

,= --7
is the unique

solution

converging

to the steady state from any initial

conditions.

4. An example
Suppose that the market rate of return is r, and consider the value of a declining firm whose
dividends are decaying to zero at rate S. The equation forecasting the value of the firm ex-dividend is
V,+1 = (1 + r)Y
while dividends

(6)

- D,+19
evolve according

D, = (1 - S)D,+,,
wherer>OandO<S<l.

to
(7)

G. Amkrson,

To apply our procedure

x,=

G. Moore

Solving

linear

perfect

foresight

to this simple model, let

The procedure

produces

(1-U

(r+ 6)

B -1=
i 0

(1-S)

As a check, recursively

substitute

eq. (6) into itself to get the usual present

+_~A_
Iterating
,+k

eq. (7), produces

(9)

(1 - G)k+'D,_l.

Combining

I/=

value formula,

(8)

k=l (1+ r).

251

models

eqs. (8) and (9) the value of the firm is

(1-aJ2D
(r+-6)

(10)

(-l

which agrees with the reduced

form computed

by the procedure.

5. Concluding remarks
The uniqueness and stability assumptions
exclude pathological models from consideration.
In the
Harrod-Domar
model [Solow (1969)] and Morishimas
(1973) model of Marxian theory, stable
solutions exist for only a subset of feasible initial conditions.
Other models such as Taylors (1977)
leading indicator
model and models described
in McCallum
(1981) have multiple
convergent
solutions for any initial conditions.
Our procedure indicates that the Harrod-Domar
model and
Morishimas
model have too many auxiliary initial conditions
and stability conditions
while the
leading indicator model has too few to determine a unique convergent solution.
A simple count of constraints is not sufficient to identify all pathological models. For example, the
model

q+1

= y,

z,=PZ,-

(11)7(12)

has solutions satisfying assumption (b) only with (~,/3 < 1. The model has the appropriate
number of
linear constraints when cy,/? > 1, even though no stable solution exists for any non-zero Z,_,. Simply
counting the number of eigenvalues on or outside the unit disc suggest the model might have a
reduced-form
solution, but checking the rank of QR indicates that LY,~> 1 is unacceptable.

This procedure for solving linear perfect foresight models serves as the nucleus of routines for
solving non-linear
perfect foresight models and for analyzing the covariance structure of solutions to
linear stochastic models. We discuss these topics in Anderson
and Moore (1984) and Moore and
Anderson (1984).

References
Anderson,
Gary and George Moore, 19R3, An efficient procedure
for solving linear perfect foresight models, unpublished
manuscript
(Board of Governors of the Federal Reserve System, Washington,
DC).
Anderson, Gary and George Moore, 19X4, An efficient procedure for solving nonlinear perfect foresight models, unpublished
manuscript
(Board of Governors of the Federal Reserve System, Washington,
DC).
McCallum.
Bennett, 1981, On uniqueness in rational expectations
models: An attempt at perspective,
Working paper 684
(NBER, Cambridge,
MA).
Moore. George and Gary Anderson, 1984, A state space method for solving linear rational expectations
models, unpublished
manuscript
(Board of Governors of the Federal Reserve System, Washington,
DC).
Morishima,
Michio, 1973. Marxs economics: A dual theory of value and growth (Cambridge
University Press. Cambridge).
Muth, John F.. 1961, Rational expectations
and the theory of price movements, Econometrica
29. 315-335.
Sargent. Thomas J., 1979, Macroeconomic
theory (Academic Press, New York).
Solow, Robert M., 1969, Growth theory (Oxford University Press, New York).
Stewart, G.W., 1976, Algorithm
506. HQR3 and EXCHNG:
FORTRAN
subroutines
for calculating
and ordering
the
eigenvalues of a real upper hessenburg matrix, ACM Transactions
on Mathematical
Software 2. 275-280.
Taylor, John, 1977, Conditions
for unique solutions
in stochastic
macroeconomic
models with rational
expectations,
Econometrica
45. 1377-1385.
Whiteman. Charles H., 1983, Linear rational expectations models: A users guide (University of Minnesota Press, Minneapolis,
MN).